I am a long term buy and hold investor who focuses on dividend growth stocks

Thursday, March 27, 2008

Diversification Matters

Last week Bear Stearns was bought by JP Morgan Chase for about $10/share. The stock has traded as high as 170 last year. Investors lost a ton of money in this stock. Employees were hard hit as well, as they own a combines % of the company through ESOP.

A review from over two million investors portfolios in a major US online brokerage, found that nearly one-third held more than 20% of their assets in just one stock. Imagine if they are invested in the next WorldCom or Enron?

There are four types of portfolio diversification in order to decrease overall risk, without sacrificing the potential rewards.

The first one is to diversify across asset classes. Each individual needs to find the appropriate asset mix of stocks, bonds, cash, real-estate and other asset classes in order to achieve the best rewards for the risk taken. During the 2000-2002 bear market, investors in the S&P 500 index fund lost 9% in 2000, in 12% 2001 and 22% in 2002. Adding a simple 20% allocation of bonds to the portfolio would have decreased the losses to 3.3%, 8.75% and 14.40% respectively.

The second strategy is to diversify within asset classes. For example stocks are broken down into:

An investor who had all of their assets in Nasdaq Stocks at the top of the dot-com bubble would have been much better off if they had invested in other asset classes. An easy way to diversify within asset classes is by buying low-cost Mutual Funds or Exchange-Traded-Funds.

Diversifying across Time is a third strategy to minimize investment risk. Although Dollar-Cost Averaging does reduce investment returns in a given short-term period (DCA) ,it reduces the risk of investing all of your funds in an underperforming asset class at the top. This increases the probability that investors would actually stick to their asset class allocation even in uncertain markets.

Diversifying across strategies is fourth way to reduce risk

Although most investors would be better off with a proper stock/bond index fund allocation adding an active strategy could reduce risk in tough times. An example of that could be investing in dividend stocks like the dividend aristocrats for example. Other types of strategies include ( but are not limited to ) selling covered calls, investing in Dogs of the Dow.

Disclaimer

I am not a licensed investment adviser, and I am not providing you with individual investment advice on this site. Please consult with an investment professional before you invest your money. This site is for entertainment and educational use only - any opinion expressed on the site here and elsewhere on the internet is not a form of investment advice provided to you. I use information in my articles I believe to be correct at the time of writing them on my site, which information may or may not be accurate. We are not liable for any losses suffered by any party because of information published on this blog. Past performance is not a guarantee of future performance. Unless your investments are FDIC insured, they may decline in value.

By reading this site, you agree that you are solely responsible for making investment decisions in connection with your funds.

Questions or Comments? You can contact me at dividendgrowthinvestor at gmail dot com.